Solutions Manual

Corporate Finance

Ross, Westerfield, and Jaffe

Asia Global Edition

01/30/2013

Prepared by:
Joe Smolira
Belmont University

1/30/2014

Revised by:

Joseph Lim
Singapore Management University

Ruth Tan
National University of Singapore
CHAPTER 17
CAPITAL STRUCTURE: LIMITS TO THE
USE OF DEBT
Answers to Concepts Review and Critical Thinking Questions

1. Direct costs are potential legal and administrative costs. These are the costs associated with the
litigation arising from a liquidation or bankruptcy. These costs include lawyer’s fees, courtroom
costs, and expert witness fees. Indirect costs include the following: 1) Impaired ability to conduct
business. Firms may suffer a loss of sales due to a decrease in consumer confidence and loss of
reliable supplies due to a lack of confidence by suppliers. 2) Incentive to take large risks. When
faced with projects of different risk levels, managers acting in the stockholders’ interest have an
incentive to undertake high-risk projects. Imagine a firm with only one project, which pays $100 in
an expansion and $60 in a recession. If debt payments are $60, the stockholders receive $40 (= $100
– 60) in the expansion but nothing in the recession. The bondholders receive $60 for certain. Now,
alternatively imagine that the project pays $110 in an expansion but $50 in a recession. Here, the
stockholders receive $50 (= $110 – 60) in the expansion but nothing in the recession. The
bondholders receive only $50 in the recession because there is no more money in the firm. That is,
the firm simply declares bankruptcy, leaving the bondholders “holding the bag.” Thus, an increase in
risk can benefit the stockholders. The key here is that the bondholders are hurt by risk, since the
stockholders have limited liability. If the firm declares bankruptcy, the stockholders are not
responsible for the bondholders’ shortfall. 3) Incentive to under-invest. If a company is near
bankruptcy, stockholders may well be hurt if they contribute equity to a new project, even if the
project has a positive NPV. The reason is that some (or all) of the cash flows will go to the
bondholders. Suppose a real estate developer owns a building that is likely to go bankrupt, with the
bondholders receiving the property and the developer receiving nothing. Should the developer take
$1 million out of his own pocket to add a new wing to a building? Perhaps not, even if the new wing
will generate cash flows with a present value greater than $1 million. Since the bondholders are
likely to end up with the property anyway, why would the developer pay the additional $1 million
and likely end up with nothing to show for it? 4) Milking the property. In the event of bankruptcy,
bondholders have the first claim to the assets of the firm. When faced with a possible bankruptcy, the
stockholders have strong incentives to vote for increased dividends or other distributions. This will
ensure them of getting some of the assets of the firm before the bondholders can lay claim to them.

2. The statement is incorrect. If a firm has debt, it might be advantageous to stockholders for the firm to
undertake risky projects, even those with negative net present values. This incentive results from the
fact that most of the risk of failure is borne by bondholders. Therefore, value is transferred from the
bondholders to the shareholders by undertaking risky projects, even if the projects have negative
NPVs. This incentive is even stronger when the probability and costs of bankruptcy are high.

3. The firm should issue equity in order to finance the project. The tax-loss carry-forwards make the
firm’s effective tax rate zero. Therefore, the company will not benefit from the tax shield that debt
provides. Moreover, since the firm already has a moderate amount of debt in its capital structure,
additional debt will likely increase the probability that the firm will face financial distress or
bankruptcy. As long as there are bankruptcy costs, the firm should issue equity in order to finance
the project.
 CHAPTER 17 -3

4. Stockholders can undertake the following measures in order to minimize the costs of debt: 1) Use
protective covenants. Firms can enter into agreements with the bondholders that are designed to
decrease the cost of debt. There are two types of protective covenants. Negative covenants prohibit
the company from taking actions that would expose the bondholders to potential losses. An example
would be prohibiting the payment of dividends in excess of earnings. Positive covenants specify an
action that the company agrees to take or a condition the company must abide by. An example would
be agreeing to maintain its working capital at a minimum level. 2) Repurchase debt. A firm can
eliminate the costs of bankruptcy by eliminating debt from its capital structure. 3) Consolidate debt.
If a firm decreases the number of debt holders, it may be able to decrease the direct costs of
bankruptcy should the firm become insolvent.

5. Modigliani and Miller’s theory with corporate taxes indicates that, since there is a positive tax
advantage of debt, the firm should maximize the amount of debt in its capital structure. In reality,
however, no firm adopts an all-debt financing strategy. MM’s theory ignores both the financial
distress and agency costs of debt. The marginal costs of debt continue to increase with the amount of
debt in the firm’s capital structure so that, at some point, the marginal costs of additional debt will
outweigh its marginal tax benefits. Therefore, there is an optimal level of debt for every firm at the
point where the marginal tax benefits of the debt equal the marginal increase in financial distress and
agency costs.

6. There are two major sources of the agency costs of equity: 1) Shirking. Managers with small equity
holdings have a tendency to reduce their work effort, thereby hurting both the debt holders and
outside equity holders. 2) Perquisites. Since management receives all the benefits of increased
perquisites but only shoulder a fraction of the cost, managers have an incentive to overspend on
luxury items at the expense of debt holders and outside equity holders.

7. The more capital intensive industries, such as air transport, television broadcasting stations, and
hotels, tend to use greater financial leverage. Also, industries with less predictable future earnings,
such as computers or drugs, tend to use less financial leverage. Such industries also have a higher
concentration of growth and startup firms. Overall, the general tendency is for firms with
identifiable, tangible assets and relatively more predictable future earnings to use more debt
financing. These are typically the firms with the greatest need for external financing and the greatest
likelihood of benefiting from the interest tax shelter.

8. One answer is that the right to file for bankruptcy is a valuable asset, and the financial manager acts
in shareholders’ best interest by managing this asset in ways that maximize its value. To the extent
that a bankruptcy filing prevents “a race to the courthouse steps,” it would seem to be a reasonable
use of the process.

9. As in the previous question, it could be argued that using bankruptcy laws as a sword may simply be
the best use of the asset. Creditors are aware at the time a loan is made of the possibility of
bankruptcy, and the interest charged incorporates it.
4 – SOLUTIONS MANUAL

10. One side is that Continental was going to go bankrupt because its costs made it uncompetitive. The
bankruptcy filing enabled Continental to restructure and keep flying. The other side is that
Continental abused the bankruptcy code. Rather than renegotiate labor agreements, Continental
simply abrogated them to the detriment of its employees. In this, and the last several questions, an
important thing to keep in mind is that the bankruptcy code is a creation of law, not economics. A
strong argument can always be made that making the best use of the bankruptcy code is no different
from, for example, minimizing taxes by making best use of the tax code. Indeed, a strong case can be
made that it is the financial manager’s duty to do so. As the case of Continental illustrates, the code
can be changed if socially undesirable outcomes are a problem.

Solutions to Questions and Problems

NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this
solutions manual, rounding may appear to have occurred. However, the final answer for each problem is
found without rounding during any step in the problem.

Basic

1. a. Using M&M Proposition I with taxes, the value of a levered firm is:

VL = [EBIT(1 – tC)/R0] + tCB

VL = [$975,000(1 – .35)/.14] + .35($1,900,000)
VL = $5,191,785.71

b. The CFO may be correct. The value calculated in part a does not include the costs of any non-
marketed claims, such as bankruptcy or agency costs.

2. a. Debt issue:

The company needs a cash infusion of $1.3 million. If the company issues debt, the annual
interest payments will be:

Interest = $1,300,000(.08) = $104,000

The cash flow to the owner will be the EBIT minus the interest payments, or:

40 hour week cash flow = $550,000 – 104,000 = $446,000

50 hour week cash flow = $625,000 – 104,000 = $521,000

Equity issue:

If the company issues equity, the company value will increase by the amount of the issue. So,
the current owner’s equity interest in the company will decrease to:

Tom’s ownership percentage = $3,200,000 / ($3,200,000 + 1,300,000) = .71

 CHAPTER 17 -5

So, Tom’s cash flow under an equity issue will be 71 percent of EBIT, or:

40 hour week cash flow = .71($550,000) = $391,111

50 hour week cash flow = .71($625,000) = $444,444

b. Tom will work harder under the debt issue since his cash flows will be higher. Tom will gain
more under this form of financing since the payments to bondholders are fixed. Under an equity
issue, new investors share proportionally in his hard work, which will reduce his propensity for
this additional work.

c. The direct cost of both issues is the payments made to new investors. The indirect costs to the
debt issue include potential bankruptcy and financial distress costs. The indirect costs of an
equity issue include shirking and perquisites.

3. According to M&M Proposition I with taxes, the value of the levered firm is:

VL = VU + tCB
VL = $17,850,000 + .35($6,000,000)
VL = $19,950,000

We can also calculate the market value of the firm by adding the market value of the debt and equity.
Using this procedure, the total market value of the firm is:

V=B+S
V = $6,000,000 + 350,000($38)
V = $19,300,000

With no nonmarketed claims, such as bankruptcy costs, we would expect the two values to be the
same. The difference is the value of the nonmarketed claims, which are:

VT = VM + VN
$19,300,000 = $19,950,000 – VN
VN = $650,000

4. The president may be correct, but he may also be incorrect. It is true the interest tax shield is
valuable, and adding debt can possibly increase the value of the company. However, if the
company’s debt is increased beyond some level, the value of the interest tax shield becomes less than
the additional costs from financial distress.
6 – SOLUTIONS MANUAL

Intermediate

5. a. The interest payments each year will be:

Interest payment = .09($85,000) = $7,650

This is exactly equal to the EBIT, so no cash is available for shareholders. Under this scenario,
the value of equity will be zero since shareholders will never receive a payment. Since the
market value of the company’s debt is $85,000, and there is no probability of default, the total
value of the company is the market value of debt. This implies the debt to value ratio is 1 (one).

b. At a growth rate of 3 percent, the earnings next year will be:

Earnings next year = $7,650(1.03) = $7,879.50

So, the cash available for shareholders is:

Payment to shareholders = $7,879.50 – 7,650 = $229.50

Since there is no risk, the required return for shareholders is the same as the required return on
the company’s debt. The payments to stockholders will increase at the growth rate of three
percent (a growing perpetuity), so the value of these payments today is:

Value of equity = $229.50 / (.09 – .03) = $3,825.00

And the debt to value ratio now is:

Debt/Value ratio = $85,000 / ($85,000 + 3,825) = 0.957

c. At a growth rate of 7 percent, the earnings next year will be:

Earnings next year = $7,650(1.07) = $8,185.50

So, the cash available for shareholders is:

Payment to shareholders = $8,185.50 – 7,650 = $535.50

Since there is no risk, the required return for shareholders is the same as the required return on
the company’s debt. The payments to stockholders will increase at the growth rate of seven
percent (a growing perpetuity), so the value of these payments today is:

Value of equity = $535.50 / (.09 – .07) = $26,775

And the debt to value ratio now is:

Debt/Value ratio = $85,000 / ($85,000 + 26,775) = 0.760

 CHAPTER 17 -7

6. a. The total value of a firm’s equity is the discounted expected cash flow to the firm’s
stockholders. If the expansion continues, each firm will generate earnings before interest and
taxes of $2,700,000. If there is a recession, each firm will generate earnings before interest and
taxes of only $1,100,000. Since Steinberg owes its bondholders $900,000 at the end of the year,
its stockholders will receive $1,800,000 (= $2,700,000 – 900,000) if the expansion continues. If
there is a recession, its stockholders will only receive $200,000 (= $1,100,000 – 900,000). So,
assuming a discount rate of 13 percent, the market value of Steinberg’s equity is:

SSteinberg = [.80($1,800,000) + .20($200,000)] / 1.13 = $1,309,735

Steinberg’s bondholders will receive $900,000 whether there is a recession or a continuation of

the expansion. So, the market value of Steinberg’s debt is:

BSteinberg = [.80($900,000) + .20($900,000)] / 1.13 = $796,460

Since Dietrich owes its bondholders $1,200,000 at the end of the year, its stockholders will
receive $1,500,000 (= $2,700,000 – 1,200,000) if the expansion continues. If there is a
recession, its stockholders will receive nothing since the firm’s bondholders have a more senior
claim on all $1,100,000 of the firm’s earnings. So, the market value of Dietrich’s equity is:

SDietrich = [.80($1,500,000) + .20($0)] / 1.13 = $1,061,947

Dietrich’s bondholders will receive $1,200,000 if the expansion continues and $1,100,000 if
there is a recession. So, the market value of Dietrich’s debt is:

BDietrich = [.80($1,200,000) + .20($1,100,000)] / 1.13 = $1,044,248

b. The value of the company is the sum of the value of the firm’s debt and equity. So, the value of
Steinberg is:

VSteinberg = B + S
VSteinberg = $796,460 + 1,309,735
VSteinberg = $2,106,195

And value of Dietrich is:

VDietrich = B + S
VDietrich = $1,044,248 + 1,061,947
VDietrich = $2,106,195

You should disagree with the CEO’s statement. The risk of bankruptcy per se does not affect a
firm’s value. It is the actual costs of bankruptcy that decrease the value of a firm. Note that this
problem assumes that there are no bankruptcy costs.
8 – SOLUTIONS MANUAL

7. a. The expected value of each project is the sum of the probability of each state of the economy
times the value in that state of the economy. Since this is the only project for the company, the
company value will be the same as the project value, so:

Low-volatility project value = .50($3,500) + .50($3,700)

Low-volatility project value = $3,600

High-volatility project value = .50($2,900) + .50($4,300)

High-volatility project value = $3,600

The low-volatility project maximizes the expected value of the firm.

b. The value of the equity is the residual value of the company after the bondholders are paid off.
If the low-volatility project is undertaken, the firm’s equity will be worth $0 if the economy is
bad and $200 if the economy is good. Since each of these two scenarios is equally probable, the
expected value of the firm’s equity is:

Expected value of equity with low-volatility project = .50($0) + .50($200)

Expected value of equity with low-volatility project = $100

And the value of the company if the high-volatility project is undertaken will be:

Expected value of equity with high-volatility project = .50($0) + .50($800)

Expected value of equity with high-volatility project = $400

c. Risk-neutral investors prefer the strategy with the highest expected value. Thus, the company’s
stockholders prefer the high-volatility project since it maximizes the expected value of the
company’s equity.

d. In order to make stockholders indifferent between the low-volatility project and the high-
volatility project, the bondholders will need to raise their required debt payment so that the
expected value of equity if the high-volatility project is undertaken is equal to the expected
value of equity if the low-volatility project is undertaken. As shown in part b, the expected
value of equity if the low-volatility project is undertaken is $100. If the high-volatility project is
undertaken, the value of the firm will be $2,900 if the economy is bad and $4,300 if the
economy is good. If the economy is bad, the entire $2,900 will go to the bondholders and
stockholders will receive nothing. If the economy is good, stockholders will receive the
difference between $4,300, the total value of the firm, and the required debt payment. Let X be
the debt payment that bondholders will require if the high-volatility project is undertaken. In
order for stockholders to be indifferent between the two projects, the expected value of equity if
the high-volatility project is undertaken must be equal to $100, so:

Expected value of equity = $100 = .50($0) + .50($4,300 – X)

X = $4,100
 CHAPTER 17 -9

8. a. The expected payoff to bondholders is the face value of debt or the value of the company,
whichever is less. Since the value of the company in a recession is $76,000,000 and the
required debt payment in one year is $110,000,000, bondholders will receive the lesser amount,
or $76,000,000.

b. The promised return on debt is:

Promised return = (Face value of debt / Market value of debt) – 1

Promised return = ($110,000,000 / $83,000,000) – 1
Promised return = .3253, or 32.56%

c. In part a, we determined bondholders will receive $76,000,000 in a recession. In a boom, the

bondholders will receive the entire $110,000,000 promised payment since the market value of
the company is greater than the payment. So, the expected value of debt is:

Expected payment to bondholders = .60($110,000,000) + .40($76,000,000)

Expected payment to bondholders = $96,400,000

So, the expected return on debt is:

Expected return = (Expected value of debt / Market value of debt) – 1

Expected return = ($96,400,000 / $83,000,000) – 1
Expected return = .1614, or 16.14%

Challenge

9. a. In their no tax model, MM assume that tC, tB, and C(B) are all zero. Under these assumptions,
VL = VU, signifying that the capital structure of a firm has no effect on its value. There is no
optimal debt-equity ratio.

b. In their model with corporate taxes, MM assume that tC > 0 and both tB and C(B) are equal to
zero. Under these assumptions, VL = VU + tCB, implying that raising the amount of debt in a
firm’s capital structure will increase the overall value of the firm. This model implies that the
debt-equity ratio of every firm should be infinite.

c. If the costs of financial distress are zero, the value of a levered firm equals:

VL = VU + {1 – [(1 – tC) / (1 – tB)}] × B

Therefore, the change in the value of this all-equity firm that issues debt and uses the proceeds
to repurchase equity is:

Change in value = {1 – [(1 – tC) / (1 – tB)}] × B

Change in value = {1 – [(1 – .34) / (1 – .20)]} × $1,000,000
Change in value = $175,000
10 – SOLUTIONS MANUAL

d. If the costs of financial distress are zero, the value of a levered firm equals:

VL = VU + {1 – [(1 – tC) / (1 – tB)]} × B

Therefore, the change in the value of an all-equity firm that issues $1 of perpetual debt instead
of $1 of perpetual equity is:

Change in value = {1 – [(1 – tC) / (1 – tB)]} × $1

If the firm is not able to benefit from interest deductions, the firm’s taxable income will remain
the same regardless of the amount of debt in its capital structure, and no tax shield will be
created by issuing debt. Therefore, the firm will receive no tax benefit as a result of issuing debt
in place of equity. In other words, the effective corporate tax rate when we consider the change
in the value of the firm is zero. Debt will have no effect on the value of the firm since interest
payments will not be tax deductible. Since this firm is unable to deduct interest payments, the
change in value is:

Change in value = {1 – [(1 – 0) / (1 – .20)]} × $1

Change in value = –$0.25

The value of the firm will decrease by $0.25 if it adds $1 of perpetual debt rather than $1 of
equity.

10. a. If the company decides to retire all of its debt, it will become an unlevered firm. The value of
an all-equity firm is the present value of the aftertax cash flow to equity holders, which will be:

VU = (EBIT)(1 – tC) / R0
VU = ($1,300,000)(1 – .35) / .20
VU = $4,225,000

b. Since there are no bankruptcy costs, the value of the company as a levered firm is:

VL = VU + {1 – [(1 – tC) / (1 – tB)}] × B

VL = $4,225,000 + {1 – [(1 – .35) / (1 – .25)]} × $2,500,000
VL = $4,558,333.33

c. The bankruptcy costs would not affect the value of the unlevered firm since it could never be
forced into bankruptcy. So, the value of the levered firm with bankruptcy would be:

VL = VU + {1 – [(1 – tC) / (1 – tB)}] × B – C(B)

VL = ($4,225,000 + {1 – [(1 – .35) / (1 – .25)]} × $2,500,000) – $400,000
VL = $4,158,333.33

The company should choose the all-equity plan with this bankruptcy cost.